Sarbanes-Oxley Act of 2002

Abstract

At the beginning of the twenty-first century, there were several high-profile corporate accounting scandals in the United States that resulted in the loss of billions of dollars worth of wealth for investors. The subsequent corporate bankruptcies—most notably Enron, WorldCom, and Adelphia—created a significant public backlash against the way large corporations managed themselves. The US Congress reacted by looking to create new laws that would reform and render corporate accounting practices more transparent and hold executives accountable for the accuracy of their firms’ financial statements. The most comprehensive of these legislative initiatives was the Sarbanes-Oxley Act of 2002 (SOX or SarbOX). This paper will more closely analyze the SOX Act, the forces that created it, and its current impact on corporate accounting practices in the United States.

Overview

In the world of business, enterprises can rise and fall with great frequency and with varying degrees of rapidity. Some are the unlikeliest of success stories, such as the sudden growth of a small Vermont ice cream shop called Ben & Jerry's into one of the most profitable ice cream businesses in the world. Others, such as finance giant Lehman Brothers, experienced a collapse that was as shocking as it was economically devastating.

In many cases, business success and failure are the result of the conditions of the markets in which they operate. Shifts in consumer demand and economic recessions or booms have a major influence on a business's viability. Then again, there are circumstances in which a business enterprise fails not as a result of external conditions but of the organization's internal decisions and policies. The Enron scandal that was revealed in 2001 provides an example, since that organization's collapse was created largely by deceptive accounting practices and mismanagement. The fact that so many businesses and investors were linked to Enron before it folded meant that its demise sent shockwaves throughout the global economy and further weakened an already anemic US economy that was struggling to recover after the terrorist attacks of September 11, 2001.

Enron's bankruptcy was one of many high-profile corporate collapses that occurred at the beginning of the twenty-first century. These corporate downfalls created a significant public backlash against the way large corporations managed themselves. Congress reacted by looking to create new laws that would reform and render more transparent corporate accounting practices. The most comprehensive of these legislative initiatives was the Sarbanes-Oxley Act of 2002 (SOX).

Further Insights

Enron: An Epic Collapse. The rise of Enron and similar energy sector companies can largely be traced to energy deregulation in the 1990s. Enron was founded in 1985 as a traditional energy company, selling natural gas to distributors and businesses ("What Happened," 2002). The brainchild of founder Kenneth Lay was a merger of two Texas natural gas pipelines, Houston Natural Gas and InterNorth, whose combined ownership of pipelines spanned thirty-seven thousand miles. At the time, prices for natural gas and other utilities were fixed and regulated, and most transactions were based on preset prices established in contracts. This condition gave Enron stability and a foundation on which growth could take place. In the mid-1990s however, stability turned to great potential, as deregulation led to more flexible contract arrangements and spot pricing (a market-derived price that is quoted within two days of trading). Enron, as the largest interstate network of natural gas pipelines, was well positioned to profit from deregulation (Healy & Palepu, 2003).

As Enron's profits grew, it began to diversify its interests, acquiring electricity, paper and water plants, among other holdings, before the cracks began to show. By 2000, the company had become a powerhouse with a business model that others emulated. Enron's reputation on the capital markets (which help generate monies for business enterprises) was unparalleled. That positive perspective continued through the summer of 2000, when the company's stock held a fifty-two-week high of $90.56. However, between 2000 and 2001, Enron's stock value began to fall. On August 14, 2001, Enron’s president and chief executive officer, Jeffrey Skilling, abruptly resigned, citing personal reasons. The company's value on Wall Street was falling precipitously, which some at the time attributed to Enron's breakup with Blockbuster on a video-on-demand broadband internet deal as well as an expensive fight with the Indian government over the construction of a power plant in that country (Forest, 2001).

Enron's shortcomings did not send up many red flags at the time. Such poor performance was explained by these two issues as well as the difficulties of an economy that was settling into recession. However, in October 2001, Enron chair Kenneth Lay announced that Enron had lost an astounding $638 million in the third quarter and disclosed a reduction in shareholder equity of $1.2 billion. The media seized on the news, and one week later Lay acknowledged that the Securities and Exchange Commission (SEC) was launching a formal investigation of Enron's use of special purpose entities (SPEs) and the company’s relationship with accounting giant Arthur Anderson LLC (Sridharan, Dickes & Caines, 2002).

Special Purpose Entities (SPE). Special purpose entities (SPEs) have been used by businesses since the 1970s and were, until the Enron scandal, widely accepted as legitimate accounting tools. An SPE is created by a business by transferring assets to it in order to carry out a specific activity or transaction. However, the accounting for an SPE is separate from the mother company—any activity conducted by an SPE is not reflected on the main business organization's balance sheet. As a result, the only liability the "sponsor" corporation has to the SPE in the event of loss is what was originally placed in the SPE. Meanwhile, the corporation's main list of assets and liabilities does not include the activities of its SPEs. Generally accepted accounting principles (GAAPs), which are a set of universally accepted accounting policies, allow for the establishment of SPEs as long as a minimum amount of capital is infused into the SPE by the parent company and the SPE's owner must take responsibility for its operation (Soroosh & Ciesielski, 2004).

The use of SPEs by Enron created an extremely complex and unclear financial image for observers. The casual observer might see the balance sheet as indicative of a major corporation undertaking little risk but generating sizable revenues. However, the failures of Enron's risky SPEs were not immediately evident, primarily because Enron was not expected to attach such losses to its own balance sheets. It was only revealed later that Enron's executives had in fact fraudulently reported profits but not debts, inflating its stock value and enabling it to obtain some capital from ignorant financial institutions and other investors ("Enron: Timeline," 2005). In November 2001, Enron admitted that, through its use of SPEs, it had inflated the company's profits and hidden its debts. Andersen, which oversaw Enron's accounting, had allegedly turned a blind eye to the Enron scheme during that period and even destroyed documents that would likely have proven damning to Enron's case. In December, Enron filed for bankruptcy, a humiliating end to one of the largest corporations. Then again, although the company was virtually dead, Enron's demise would only be the beginning. A major, high-profile investigation was launched shortly after the "funeral."

Setting the Stage for Sarbanes-Oxley. In May 2006, a Texas jury found Kenneth Lay and Jeffrey Skilling guilty of fraud and conspiracy. Their convictions were among many in the years that immediately followed the revelations about Enron's misdeeds. Their actions destroyed Enron's stock, which in turn decimated the retirement savings that were invested heavily in the energy giant. Lay and Skilling were also responsible for the losses of nine thousand jobs and about $68 billion in market capital (Kelemen & Jelter, 2006).

Meanwhile, Arthur Andersen was publicly pilloried for destroying documents that appeared to have covered up Enron's fraudulent activity. That company was convicted in 2004 of obstruction of justice and its reputation was smeared (particularly in light of its relationship with another high-profile corporate scandal and bankruptcy at WorldCom). Andersen was later redeemed, as it became clear that there was no evidence of wrongdoing (Morrison, 2004). In 2005, when it was learned that the Department of Justice had provided a vague argument to the jury of Andersen's culpability in illegal behavior, the US Supreme Court unanimously overturned the conviction. However, the damage had already been done; Arthur Andersen virtually disappeared, reducing a staff of twenty-eight thousand before the scandal to a mere two hundred afterward (Mears, 2005).

The Enron scandal involved many parties, including President George W. Bush and many members of Congress (on both sides of the aisle), all of whom had received campaign contributions and/or invested their own funds in Enron stock. Public outrage was high, particularly since Enron's collapse was not the only high-profile bankruptcy to occur at the time. Congress was therefore under a great deal of pressure to produce a legislative response that would address the issues that made these scandals possible. The most prominent of these responses was the Sarbanes-Oxley Act.

Some have asserted that the SOX Act was a reactionary measure that was focused on public sentiment rather than initiating true reform. Hearings for the bill, which was authored by Senator Paul Sarbanes (D-Maryland) and Representative Michael Oxley (R-Ohio), began in 2001, only two months after Enron’s bankruptcy declaration. In fact, the legislation was decades in the making. In the 1970s, after the bankruptcy of railroad giant Penn Central, Congress began looking at the creation of an accounting oversight board (a central element of the SOX Act) to prevent further high-profile bankruptcies. In the 1990s, the idea of accounting oversight again surfaced, only to be taken off the table, as it would have been politically unpopular in light of the economic boom of the period (Fass, 2003).

Important Elements of SOX

Public Company Accounting Oversight Board. After the corporate scandals of the early twenty-first century, Congress revisited these concepts in SOX. The centerpiece of the SOX Act was the creation of the Public Company Accounting Oversight Board (PCAOB). The PCAOB registers and regulates all public accounting firms. Among its responsibilities is inspecting such organizations, conducting investigations and disciplinary proceedings, and enforcing compliance from such enterprises with the establishment of professional standards. Registration with the PCAOB is mandatory for all such firms, which are also required to maintain and make available records spanning up to seven years. Although the PCAOB is able to work with certified public accountant (CPA) groups and organizations, the Board maintains full authority to set and enforce standards (NYSSCPA, 2009).

Title IV. In addition to the creation of the PCAOB, the SOX Act reinforced the standard accounting rules and regulations with which all financial disclosures must comply. Along with the existing standards for accounting, SOX added a number of new rules for transparency, including one that is believed to be at the heart of the Enron scandal.

Title IV of the SOX Act made it mandatory for businesses to disclose any and all information about their respective SPEs, including their current and potential impact on the parent businesses. Furthermore, Title IV prohibits the use of "pro forma" calculations, or figures that are based on an assumption that a transaction will take place (Grill, 2010). Enron and other failed corporations used pro forma calculations to inflate their earnings and mislead the public about the company's performance. Additionally, Title IV strictly prohibits any personal loans by the corporations to their executives and applies new rules to executives to curb fraudulent behavior by such personnel.

The SOX Act was a major legislative response that looked to prevent other business organizations from committing transgressions similar to those of Enron. The bill also was presented as a high-profile political and national response to the firestorm that Enron's demise had created.

Discussion

The Significance of SOX. The Sarbanes-Oxley Act of 2002 was significant for its strong response to the scandals of Enron, WorldCom, and other major corporations. Indeed, big business was thrust into the harsh critical eye of the public, which had quickly condemned Enron even before the first official indictments were issued. Those scandals also involved a major accounting firm, Arthur Andersen, which was found guilty in the court of public opinion before evidence showed it was not necessarily complicit.

Because it was largely focused on accounting practices, the SOX Act's biggest impact was felt in the field of accounting. According to Dorothy A. Feldmann and William J. Read (2010), after the passage of Sarbanes-Oxley, accounting professionals demonstrated a more conservative approach in their activities. Such behavior could be attributed to the spotlight cast on accounting firms after Enron. However, they concluded that SOX had a major impact on the decision-making processes of auditors and accounting professionals.

There were also international implications of the SOX Act. The Act also applied to publicly traded business enterprises, including those businesses that trade on US markets. There are many international business organizations that also trade on Wall Street, and it is understood that these corporations must comply with the SOX Act as well. After all, the legislative intent of SOX was to safeguard US financial markets against illicit activity such as that which Enron and others committed. Many European businesses lobbied against passage of Sarbanes-Oxley during the legislative process. However, their efforts fell short, as the rules of international public law gives the United States the right to create extraterritorially effective legislation to counter corporate behavior that will affect US markets. Furthermore, the European effort to undermine SOX was received tepidly by Europeans themselves, who had seen similar scandals take place in European Union countries and therefore did not have as much of an issue with the American effort (Hellwig, 2007).

Some accounting firms and business groups bristled at the Act's establishment of the PCAOB. The PCAOB, these groups argued, was an independent board whose members were appointed by the SEC, which would also oversee the PCAOB's activities. The Free Enterprise Fund, an accounting firm, brought the case against the PCAOB shortly after the Board's establishment. The plaintiffs argued that the PCAOB's members were given executive powers but could not be removed by the president; as such, the plaintiffs argued, the PCAOB was unconstitutional. The case was twice defeated in lower courts before it was brought before the US Supreme Court in the spring of 2010 (Cohn, 2010). During the Supreme Court justices' deliberations, concerns were raised that if they found for the plaintiffs, the SOX Act would need to be rewritten altogether, a possibility that the leaders of the Free Enterprise Fund acknowledged could enable them to change other harsh regulations (Norris, 2009).

In late June, the Supreme Court handed down a decision that said that the SOX Act would not need to be rewritten and could remain on the books. However, the plaintiffs won a partial victory in the case, as the Court, by a 5–4 decision, ruled that the PCAOB's members could be removed at will by the SEC (Hilzenrath, 2010). Chief Justice John Roberts, writing for the majority, said that the decision gave the SEC greater flexibility to remove Board members (under the law, the SEC could only remove a member after having shown good cause) while keeping intact and enforcing the SOX Act.

Due to the SOX Act's aim to ensure greater transparency from companies regarding their financial statements (including arrangements made off of their balance sheets), in 2016, the Financial Accounting Standards Board passed a new rule requiring every firm that leases any of its assets for a period of more than twelve months to report that lease on its balance sheet as it should be noted as an economic liability (Weidner, 2017).

Conclusion

The Sarbanes-Oxley Act of 2002 was born of the illicit actions of Enron and WorldCom executives and the glaring accounting loopholes they exploited. As this paper has demonstrated, SOX was the culmination of decades of work to strengthen American accounting practices, even if those practices were included in the GAAP. The SOX Act led to a change in attitudes about accounting and financial reporting in the corporate world. More than fifteen years after its passage, the law remains both significant and relevant.

Terms & Concepts

Enron: A major energy company based in Houston, Texas, that folded in 2001 amid public scandal and fraud.

Generally Accepted Accounting Principles (GAAP): Internationally recognized procedures for accounting and financial reporting.

Public Company Accounting Oversight Board (PCAOB): Established by the Sarbanes-Oxley Act of 2002 to provide oversight to all public accounting firms.

Special Purpose Entities (SPE): Third-party business groups that are designed to carry out a single activity or operation as separate from but dictated by a major corporation.

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Suggested Reading

Bartov, E. & Cohen, D. (2009). The "numbers game" in the pre-and post- Sarbanes-Oxley eras. Journal of Accounting, Auditing & Finance, 24, 505–534. Retrieved August 5, 2010 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=45580278&site=ehost-live

Cohn, M. (2017). As SOX hits 15, ethics fall short. Accounting Today, 31(9), 34–35. Retrieved March 2, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124964991&site=ehost-live&scope=site

Dey, A. (2010). The chilling effect of Sarbanes-Oxley: a discussion of Sarbanes-Oxley and corporate risk-taking. Journal of Accounting and Economics, 49(1/2), 53–57.

Kros, J. & Nadler, S. (2010). The impact of Sarbanes-Oxley on off-balance sheet supply chain activities. Journal of Business Logistics, 31, 63–77. Retrieved August 5, 2010 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=49739128&site=ehost-live.

Lenn, L. E. (2013). Sarbanes-Oxley Act 2002 (SOX) 10 Years Later. Journal of Legal Issues and Cases in Business, 2, 1–14. Retrieved November 22, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=91096089

Orin, R. (2008). Ethical guidance and constraint under the Sarbanes-Oxley Act of 2002. Journal of Accounting, Auditing & Finance, 23, 141–171. Retrieved August 5, 2010 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=28106551&site=ehost-live

Seitzinger, M. (2010, July 21). Section 404 of the Sarbanes-Oxley Act of 2002 (Management Assessment of Internal Controls): current regulation and Congressional concerns. Congressional Research Service. Retrieved August 5, 2010 from EBSCO Online Database GalleryWatch CRS Reports. http://search.ebscohost.com/login.aspx?direct=true&db=glw&AN=RS22482.2010 -07-21&site=ehost-live.